Open-Economy Macroeconomics and Exchange Rate

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Open-Economy Macroeconomics

Macroeconomics has two kinds of economies. One is the open economy and the other is the closed economy. An open economy is an economy in which trading activity takes place between all the countries. That means it allows the buying and selling of goods and securities from the neighbouring countries. It is an international activity. Whereas the closed economy is an economy in which all the trading activities have taken place within the country. It doesn't allow foreign trade and investments.


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Exchange Rate Quotations

The exchange rate is a rate which is known as the amount of currency which we can observe when it is converted into other currency. The difference between the two currencies for the same value of money is known as the exchange rate.


Exchange rate quotations are available in two different ways. One is a direct quotation, and the other is an indirect quotation. While discussing the exchange rates, we need to learn about the fixed currency and variable currency. Let's take two countries, the one currency which we are going to express in terms of the other country's currency. The first currency is the fixed currency, and the currency in which we are expressing is nothing but the variable currency because it may change from time to time.


Direct Quote and Indirect Quote

A direct quote is one way of quotation in which the single unit of foreign currency is expressed in terms of our currency which is the domestic country. Then it is known as a direct quote.


On the contrary, an indirect quote is another way of quotation in which the single unit of domestic currency has been expressed in terms of foreign currency, then it is called an indirect quote.


Illustration

If we take an Indian rupee as the domestic currency, then

Direct quote is

1 USDĀ  = 74 INR (say)

And Indirect quote is,

1 INR = 188 Rp( Indonesian rupiah)


Components of the Exchange Rate - HE

The exchange rate has two different components. One is based currency, and the other one is the counter currency. These concepts are similar to the meaning of direct quotes and indirect quotes.


The foreign currency will act as a base currency, and the domestic currency is as the counter currency while using direct quotations. In contrast, the foreign currency is the counter currency, and the domestic currency is the base currency in the indirect quotation. Also, the Indirect rate in foreign exchange means the conversion rate will be expressed in terms of foreign currency for a single rupee of Indian currency If we take India as our domestic country. Similarly, the Direct quote currency is the currency of our domestic country because we express our currency in terms of foreign currency in this case.


As of now, we have learned the two kinds of foreign exchange quotations; we also need to understand various kinds of exchange rates because the direct quote and indirect quote are available for every kind of exchange rate. So, to implement the direct quotation and indirect quotation for every kind of exchange rate, we need to understand all the types of exchange rates.


Types of Exchange Rates

We have different kinds of exchange rate systems. Let us see the basic types of exchange rates.

  • Fixed Exchange Rate:

The name itself explains that the exchange rate is fixed and prescribed by the government of that particular country. These mostly happen in dominant countries. USD is the best example of this. It is also known as the pegged exchange rate system.

  • Floating Exchange Rate:

It is quite the opposite to the above one. The exchange rate of which may not be constant and keep on changes based on the market conditions. Because it is decided based on the market conditions, several countries adopted these floating exchange rate systems.

  • Spot Exchange Rate:

Another type of exchange rate which can be specified the exact value at present. It means the value which can be mentioned at this particular point in time is nothing but a spot exchange rate. It may change from one day to another.

  • Forwarded Exchange Rate:

It majorly happens in trading activity. If the seller is restricted to sell his goods for months on a future date to get increased conversion value, these exchange rates are known as forwarded exchange rates. And the system using these rates is nothing but the forwarded exchange rate system.

  • Dual Exchange Rates:

The name itself specifies that it has dual values. It means that the same good or in bond May possess one value for international trade and the other value for domestic trade. Then these rating systems are known as a dual exchange rate system.


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Conclusion

Hence, we understood that the exchange rate is a rate of conversion that occurred from one currency to another currency. It is of two types in its notations. Both direct quotation and indirect quotation have their unique advantages along with few limitations.

FAQ (Frequently Asked Questions)

Q1. What do you Mean by NEER and REER?

Ans: NEER is a nominal effective exchange rate and REER is a real effective exchange rate. These two are used as indicators and also called indices. The nominal effective exchange rate is used to indicate a bilateral nominal exchange rate between the foreign currency. In contrast, the real effective exchange rate is a weighted exchange rate to explain the difference between the conventional rates of foreign currencies. It takes part in purchasing activities.

Q2. What are the Merits and Demerits of an Open Economy?

Ans: Merits of the Open Economy:

  • It provides a facility to expand the businesses and income levels across the globe.

  • It increases the competition between the sellers available in the domestic nation.

  • It creates awareness regarding the quality and the technology etc. aspects from foreign products and trading activities.

  • It helps to create more employment opportunities.

Demerits of the Open Economy:

  • By keeping attention on profits, the seller's May reduce the quality of goods to survive themselves in the competition.

  • Consumers may get more attracted to foreign products than domestic ones.

  • The over-enthusiasm may lead to the Independence of an entrepreneur and in turn, makes him get less income.

  • Exchange rates may create certain problems during trading activities.

Q3. What is an Exchange Rate System?

Ans: The system or a central legal body that uses the kind of exchange rate, then it is said to be that particular kind of exchange rate system. It is of three major types. They are:

  • Fixed exchange rate system.

  • Floating exchange rate system.

  • Managed exchange rate system.

Apart from these three, we have other kinds of exchange rate systems available, but several countries widely use these.